The tax system explained in beer

Oaktree’s Howard Marks recent newsletter (always worth a read) finished with a simplified example of a progressive tax system using the metaphor of beer.

While this example has been floating around for a while and used by many different people in different countries with progressive tax systems, I have altered the example to better reflect Australia’s tax system.

Like all illustrative examples, simplifying the issue means glossing over the complexities of the overall system, nevertheless it is interesting. I would like to emphasise here that the example below is a light hearted example of the tax system.

Suppose that once a week, ten men go out for beer and the final bill comes to $100. If they split their bill according to how income taxes are calculated, each of the men would pay the following amount:

 The four poorest men would pay nothing.

The fifth poorest would pay $2.

The sixth would pay $5.

The seventh would pay $8.

The eighth would pay $13.

The ninth would pay $19.

And the tenth (the richest) would pay $53.

 The ten drank in the bar every week, satisfied with their arrangement until, one day, the owner caused them a little problem. “Since you are all such good customers,” he said, “I’m going to reduce the cost of your weekly beer by $20.” Drinks for the ten would now cost just $80.

 All being good friends the group decided to proceed as they had been when it came time to pay. So, the first four men were unaffected. They would still drink for free but what about the other six men? The paying customers? How could they divide the $20 windfall so that everyone would get his fair share?    

 They realised that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man end up being paid to drink his beer.

 The bar owner suggested that it would be fairer to reduce each bill by a higher percentage the poorer he was to follow the principle of the tax system they had been using and he proceeded to suggest the new lower amount that each should now pay.

 And so, the fifth man, like the first four, now paid nothing (a 100% saving).

The sixth man now paid $3 instead of $5 (a 40% saving).

The seventh man now paid $6 instead of $8 (a 25% saving).

The eighth man now paid $10 instead of $13 (a 23% saving).

The ninth man now paid $15 instead of $19 (a 21% saving).

And the tenth man now paid $46 instead of $53 (a 13% saving).

Each of the last six was better off than before with the first four continuing to drink for free.

 But, once outside the bar, the men began to compare their savings.

“I only got $2 out of the $20 saving,” declared the sixth man. He pointed to the tenth man, “but he got $7! “

 “Yeah, that’s right,” exclaimed the fifth man. “I only saved a $2 too. It’s unfair that he got 3 times more benefit than me!”

 “That’s true!” shouted the seventh man. “Why should he get $7 back, when I only got $2? The wealthy get all the breaks!”

 “Wait a minute,” yelled the first four men in unison, “we didn’t get anything at all. This new tax system exploits the poor!”

 Feeling uncomfortable with the negative attention he was receiving from his group, the tenth man decided to remove himself from the group’s weekly social activity and no longer went to  the bar.

 The following next week, the nine men sat down and had their beers without the tenth man. But when it came time to pay the bill, they discovered something important – they didn’t have enough money between all of them to pay for even half of the bill!

 That is how our tax system works. The people who already pay the highest taxes will naturally get the most benefit from a tax reduction.

 It is important to remember that tax can be a hot-button issue, everyone’s experience is different,

Marks pointed this using the example, saying “everyone’s view of the fairness of the tax system – like most such matters – depends largely on the angle from which you look at it.”

Posted in Informative, Money.